Fed’s Next Move May be a Rate Hike

What You Missed

Last week’s downbeat mix of data and events, which confirmed that both the Fed’s inflation fight has stalled, and US economic growth remains on trend, led interest rate markets to one conclusion: the Fed probably isn’t cutting rates at all this year and its next move could even be a rate hike. How could this happen? How could all the interest rate prognosticators of the world (including us) be so wrong for so long? It seems there’s one answer: Fed Chair Jerome Powell’s pivot toward rate cuts at the December 2023 post-meeting press conference created a surge in stocks and bonds (lower long-term rates), which has kept inflation uncomfortably high while strengthening the jobs market.

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Running the Numbers: Rates Stuck at Highs of the Year as Fed Recalibrates Policy

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Interest rates treaded water near their year-to-date highs as market expectations continued to shift from a “when” to an “if” outlook on interest rate cuts.

For the week:

Where will SOFR be a year from now? 3-month (CME) Term SOFR, a valuable gauge for the true cost of interest rate hedging, held steady at 5.32%. The implied yield on the 3-month SOFR futures contract 1-year forward (March ‘25), an estimate of where markets expect 3-month Term SOFR – and by extension, hedging costs – to be a year from now, rose five basis points week-over-week to 4.80%, reflecting financial markets that have thrown in the towel on hopes for any near-term interest rate cut.

How much higher will SOFR rise? 1-month SOFR, via the SOFR forward curve, implies that one-month SOFR has peaked near 5.33% and will decline precipitously over the next year as the Fed eventually cuts interest rates in early 2025. The forward curve projects that 1-month Term SOFR will steadily decline from here on out, eventually bottoming out near 4.01% in January 2028. While the forward curve isn’t a forecast – it’s proven to be a horrible predictor historically – it does give one a peak at the market’s current thinking, and at the moment, reflects the view that interest rates won’t decline in any significant way anytime soon, and that long-term rates will settle higher than once thought.

Where is the 10-year Treasury yield headed? The 10-year Treasury yield forward curve implies that the yield will bottom out at 4.65% in November 2024, then stage a slow and steady sequential rise.

When will rate cap costs decline? Rate volatility, a vital driver of the cost of option-based interest rate hedges like rate caps, declined week over week on mellowing Middle East tensions but is still sitting at a 2-month high. Rate cap costs continue to hover 25-30% below their peaks and will likely continue their downward path as the first Fed rate hike gets closer.

Curious about what a rate cap costs? Check out our rate cap calculator.  The calculator is a valuable tool for providing an estimate, but if the expected start date is a couple of months away or the cap’s notional amount is amortizing/accreting, give us a call, 415-510-2100, for indicative pricing based upon the specific economics.

Elsewhere, equities were firmer on the week, though trading was choppy. Easing geopolitical concerns and generally upbeat earnings reports helped offset interest rate jitters. The price of a barrel of West Texas Intermediate crude oil rose $1.03 from this time last week to $83.84, as the US dollar weakened and Gold strengthened, the latter trading near all-time highs.

Slowing Growth Yet Another Sign Fed Will Stay on the Sidelines – Or Is It?

A couple of data points shook markets to their core last week, with Q1 GDP, released last Tuesday, showing that economic growth cooled much more than expected.

Headline GDP growth fell to 1.6% in Q1, notably lower than the 3.4% seen in Q4 2023, well below the 2.5% expected and below the Fed’s 2.1% projection for all of 2024.

But wait, isn’t slower growth just what the Fed needs to justify a rate cut? Sure, but when you peel back the onion on the data, one would see that after subtracting volatile categories like business inventories and international trade, GDP growth was on trend, and likely to keep inflationary pressures uncomfortably high. To boot, if one observes the most real time measure of US GDP that exists – the Atlanta Fed’s GDPNow gauge, now sitting at a whopping 3.9% – you’d conclude that the Fed has zero reason to entertain a rate cut. If anything, should the GDP trend continue, the Fed would have growing justification for a rate hike. For now, the Fed will look through the weaker headline GDP number, and work towards, over the coming weeks, reshaping market expectations for rate cuts.

PCE Data Confirms the Fed’s Stalled Progress at Calming Inflation

The Personal Consumption Expenditures index (PCE) is the Fed’s preferred gauge of the level of prices – aka inflation – US consumers pay for goods and services.  While financial news organizations and businesspeople fawn the Consumer Price Index (CPI), the PCE index is known for capturing inflation (or deflation), spending momentum in both urban and rural areas, and changes in spending behavior across a wide range of consumer expenses. Confused by PCE versus CPI? Here’s your primer for understanding the difference.

Sparing you the boring details of the data release, know that supercore PCE inflation, Fed Chair Powell’s favorite inflation gauge, rose 0.4% in March, vs. 0.2% prior, driven by transportation services and other broad services. The three- month annualized rate – a measure of inflation’s momentum, rose to 5.5% (vs. 4.9% prior), while the six-month annualized rate eased to 3.8% (vs. 4.0% prior). Personal incomes were also shown to have increased above expectations while the savings rate declined.

Why it matters: The Fed has been on high alert for any signs of dissipating inflation pressures, but unfortunately, the PCE data showed just the opposite: employment and wage growth are boosting incomes and spending and are showing no signs of calming. This means that core inflation will persist, keeping interest rates higher for even longer and forcing the Fed to maintain its on-hold stance possibly through year end.

What to Watch: Fed to Abandon Rate Cut Talk in Favor of Higher….Forever?

The recent hot CPI and PCE inflation data, along with a solid reading of Q1 GDP have created the necessity for the Fed to shift toward a hardened stance on interest rates at this week’s monetary policy meeting (Wednesday). No one expects the Fed to cut rates this week, the focus will be on any pivot in the tone of the post-meeting statement and Chair Jerome Powell’s press conference.

Several Fed officials have been hinting at such in their public statements over the last couple of weeks, citing stubbornly high inflation, rising wages and spending as reasons for the need for the Fed to shift toward a more aggressive approach at fighting inflation. Could that shift be a pivot toward – gasp – rate hikes? Probably not just yet, as it would probably take either a serious global supply or inflationary shock for rate hikes to become a realistic possibility. And even then, the Fed would probably prefer to hold interest rates steady at their high level unless the shocks looked to spark a broader and more persistent inflation problem. In the meantime, the Fed will likely now go out of its way to imply that rates are indeed set to remain high for even longer, with the veiled threat that the Fed stands ready to do whatever it takes – barring cratering the economy – to get inflation sustainably down to its 2% target.

For now, the Fed seems hopeful that it’s policy will bring inflation down to sustainable levels – eventually. One notable observation is their optimistic outlook on how immigration can help lower inflation while maintaining a robust jobs market – sort of the Fed’s dream scenario.

Another wrinkle we’re watching is if labor productivity (a statistic that’s part of Friday’s jobs report) accelerated less than what’s been implied by the recent string of prior jobs reports this year. Labor productivity may now be growing more slowly now (a valid expectation if most of the surge in jobs is made up by low-skilled workers). If so, then the jobs market will probably have to slow even more than it would otherwise to bring down inflation to the Fed’s 2% target.

Finally, it’s also possible, but unlikely, that the Fed just chooses to accept inflation sustainably above its 2% target (CPI inflation is 3.5% now year-over year) while opting to sit on its hands in hiking or cutting rates. With all the focus on inflation lately, and specifically how successful the Fed will ultimately be in getting it down to its 2% target, it’s useful to know where the 2% target came from in the first place:  The origin of the Fed’s 2% Inflation Target.

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